What Didn't Change When Nixon Cut the Gold Link

The monetary system that dates back to August 1971 shares one vital trait
with its predecessor...

"Let me lay to rest the bugaboo of what is called devaluation," Richard Nixon
told his fellow Americans on August 15 1971.

The 37th President had
just announced the US would "temporarily" close the gold window - ending
the convertibility of Dollars into gold that
had been key to the postwar Bretton Woods system.

What didn't change in 1971, though, was every bit as important as what did.
Because the Dollar remained the world's reserve currency - a "privilege" that,
four decades on, looks increasingly like a curse.

When he made his address, Nixon was keen to allay fears he was undermining
the Dollar's value by cutting the link to gold - especially given the apocalyptic
warnings (both in the press and inside the White House) of how disastrous such
a move would be.

His pitch? "If you want to buy a foreign car or take a trip abroad, market
conditions may cause your Dollar to buy slightly less. But if you are among
the overwhelming majority of Americans who buy American-made products in America,
your Dollar will be worth just as much tomorrow as it is today. The effect
of this action, in other words, will be to stabilize the Dollar."

Any British viewers that day would have found it eerily reminiscent of prime
minister Harold Wilson's "Pound
in your Pocket" speech four years earlier. Nothing would change besides
the entire monetary structure. And now, back to your scheduled programming
with Bonanza.

Here in 2011, it's now been 40 years since the "temporary" suspension of Dollar
convertibility. Has the Dollar been "stabilized"? Clearly not. But what's worth
noting is how much faster the Dollar's domestic purchasing power has fallen
in the last four decades - freed from gold -
than it did in the 40 years before Nixon's announcement.

Of course, Nixon tried to spin his economic reforms - the gold window closure
was accompanied by a wage and price freeze and a 10% import tariff - as necessary
for "building the new prosperity". The logic was clear. A devalued Dollar,
aided by the import tax, would increase America's international competitiveness,
while wage and price controls would prevent these policies feeding through
into higher inflation.

At least, that was the plan. As we know, it didn't turn out too well on the
inflation front. But higher rates of inflation aren't the only phenomenon we've
seen since the early 1970s. The irony is, Nixon hoped to solve another problem
by closing the gold window - the US trade deficit.

"The United States has always been, and will continue to be, a forward-looking
and trustworthy trading partner," he reassured the world on that fateful August
evening. Within a minute, Tricky Dicky announced the 10% tax on imports.

Nixon hoped to improve America's trade balance. Indeed, that was one rationale
behind devaluing the Dollar by de-pegging it from gold. But it didn't work:

The United States has not run a trade surplus since 1974. It has consistently
imported more goods and services than it has exported. Most countries cannot
do this for long. They need the revenues from exports to pay for imports.

The US is different, because it issues the world's only reserve currency,
which is used to settle most international trade. France's finance minister
under president Charles de Gaulle, Valéry Giscard D'Estaing, described
this in the mid-1960s as America's "exorbitant privilege" - the ability of
the US to fund its trade gap by the creation of new Dollars, in which its imports
are still denominated.

With gold convertible for Dollar
bills, this "privilege" risked emptying the United States' huge stockpile of
monetary metal. But freed from that gold obligation in 1971, isn't the privilege
actually still a curse today?

The US was in a tricky position throughout the Bretton Woods era. Its problem
was summed up by what became known as the Triffin Dilemma, after Belgian economist
Robert Triffin. Because as the global economy expanded, he explained, more
and more Dollar liquidity was needed to oil the wheels of international trade.
And the US was the sole issuer of Dollars. So the only way the rest of the
world could obtain Dollars was by exporting more to America than it imported
- all but ensuring the US would run a trade deficit.

Of course, the US could seek to match its exports to its imports - but that
risked a seize-up of global trade if foreigners could not get hold of sufficient
Dollars to settle their trading with other, non-US parties.

That was one part of the Triffin Dilemma. The other concerned the link to gold,
fixed at $35 an ounce. As more and more Dollars entered the system, so the
ratio of Dollars to gold increased, putting upwards pressure on the Dollar gold
price.

The open market gold
price rose, accelerating the drain on US gold reserves, as arbitrageurs
realized they could swap $35 for an ounce of US government gold and sell
it for more elsewhere.

The fixed exchange regime of Bretton Woods, resting as it did on a $35 an
ounce gold price,
was unsustainable in a world of ever-increasing Dollar liquidity. Nixon had
three choices - close the gold window, risk setting off a global deflationary
spiral, or give away the United States' remaining stockpile of metal. He closed
the window.

The Dollar, however, remained the world's reserve currency. This meant the
US was now in a position - both at home and abroad - to really go to town exploiting
D'Estaing's exorbitant privilege. And looking back over the last 40 years,
it looks like that's exactly what successive administrations did.

We hear a lot today about "imbalances" in the global economy. One of the biggest
imbalances is that the monetary unit of international trade is issued by a
single nation. Gold was giving a strong signal of this disequilibrium half
a century ago. Nixon, however, either misread the signals or willfully ignored
them. Instead he blamed the Dollar's travails on "international money speculators".

By doing so, he pushed the world onto a whole new monetary system, one whose
ultimate backing is the "Full Faith and Credit" of the United States government
- and nothing more. It's a worrying irony that a system resting on such "faith
and credit" was mid-wifed by the man responsible for Watergate.

Editor of Gold News, the analysis
and investment research site from world-leading gold ownership service BullionVault,
Ben Traynor was formerly editor of the Fleet Street Letter, the UK's
longest-running investment letter. A Cambridge economics graduate, he is a
professional writer and editor with a specialist interest in monetary economics.

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